PharMerica PMC

Investment Thesis
PharMerica (PMC) is a timely short and the fair value of the company could be more than 45% lower than the current market capitalization. It seems irrational that a cash flow negative company that loses 15% of its customers per year should be valued at a premium multiple. Bulls of PMC will cite the demographic tailwinds but will ignore the major headwinds facing the company over the next year. The loss of two major contracts and the recent court case filed by the Department of Justice will slowly wake up longs and true value will be restored.

Background

PharMerica operates behind Omnicare as the second largest institutional pharmacy services company in America. The business is centered around organizing prescriptions for non-hospital medical centers to allow for more efficient dispensing of drugs.

The popular view is that companies like PMC will come in, consolidate the industry, and reap the rewards of an aging society. The problem is that their customer base is seeing constant attrition and must acquire new beds each and every year. Over the past three years over 51,000 beds per year have been loss. The results can be seen in the table below.

Table 1. Bed Losses Source 10K's

Customer licensed beds	2008	2009	2010	2011	2012
Beginning	336,759	320,862	313,364	361,154	337,213
Additions	21,398	35,921	95,949	30,460	21,198
Losses	(37,295)	(43,419)	(48,159)	(54,401)	(51,403)
% Losses	-11.1%	-13.5%	-15.4%	-15.1%	-15.2%

The math here is straightforward: more beds = more prescriptions = more revenue. Inversely this results in: less beds = less prescriptions = less revenue. The company has to replace all lost beds to keep revenue up so it should be fairly obvious that PMC must constantly acquire to keep revenue flat.

Thanks to GAAP accounting the company appears to generate positive earnings and positive free cash flow(Operating cash flow less CapEx), since acquisitions are deemed one time financing charges. This is incorrect though because acquisitions are an ongoing expense and should not be regarded as one-time expenses. The table below shows the impact that acquisitions have.


Table 2. Free Cash Flow and the Impact of Acquisitions Source: 10K's

In Millions	2007	2008	2009	2010	2011	2012
FCF	$(18.2)	$31.1	$52.2	$39.9	$52.4	$41.6
FCF after acquisitions	$(23.8)	$5.2	$(2.5)	$(80.8)	$1.4	$(43.2)

On the surface PMC generated $199M in FCF in the past six years, but after acquisitions the company has actually burned through $143.7M in the past six years. This is clearly a business with structural difficulties and the balance sheet is becoming bloated with debt (variable rate L+2.75%) and goodwill.

Table 3. Change in Balance Sheet

In Millions	2008	2009	2010	2011	2012
Cash & Cash Equivalents	$41.3	$51.2	$10.8	$17.4	$12.3
Long-term Debt	$240	$240	$245.6	$300	$315.5
Goodwill	$113.7	$140.1	$179.4	$214.9	$268.2
Tangible Book Value	$132.7	$140.0	$102.8	$98.7	$52.5

A simple screen will show book value increasing every single year, but that is simply because goodwill is rising. Tangible book value, a much better indicator shareholder returns, has declined every single year since 2009. It is easy to understand why this is the case when incentives are examined.

Management Incentives

In 2012 the company lost $43.2M after taking acquisitions into account. As I have shown in Table 2, losing money is not unusual but this has not impacted management. The reason for this is simple, management is compensated on Adjusted EBITDA and Adjusted EPS levels. Therefore, the incentive is to acquire beds at any cost to boost EBITDA/EPS and have constant "merger, acquisition, and integration costs" that are stripped out. With $81.7M allocated to merger, acquisition, and integration costs over the past five years management has reaped the rewards of this strategy while shareholders have suffered.

Even a standard definition of EBITDA, itself a poor metric of true cash flows, would have resulted in significantly lower pay for management.

Large Contract Losses

I believe the pace of acquisitions will need to accelerate because the two largest customers of PMC are leaving. Kindred announced their intent to leave PMC in June of 2013 and Golden Living announced they were leaving in 2012. Kindred's nursing facilities were 11.5%(~$183M) of PMC's 2012 revenues and this will be gone in 2014. When the news release came out, PMC shares lost 16% but over the ensuing 45 days rallied back to within 6% of 52 week highs. Bulls seemed to ignore all implications of the lost contract.

The loss of the Golden Living contract could prove far worse for PMC than most analysts believe. Golden Living is not simply switching to another provider, they have decided to start their own prescription management company, AlixaRx. The company hopes to become #3 in the industry and take 20% market share in a few years. Obviously they have not done this yet and the future is always uncertain, but who better to take market share than the owners of the largest nursing home chain? Losing two large contracts and having a well-funded knowledgeable group nipping at your heels can't be good for the business.

Again, bulls seemed unfazed by this loss and the potential competition. Shares were bid up and over the next seven months PMC would beat the S&P by more than 10%. Next year revenue will be hit much harder and if that doesn't wake up bulls the potential fines for illegally prescribing Schedule II drugs will.

DEA Investigation

On August 9, the DOJ announced charges against PMC alleging violation of False Claims Act and the Controlled Substances act. PMC allegedly "dispensed controlled drugs several thousand times without first getting valid written prescriptions from treating doctors, and caused false and fraudulent claims to be submitted to Medicare at least 250 times."

The case isn't new and these violations were reportedly told to PharMerica management in 2009. According to the lawyer representing Jennifer Buth, the pharmacist who first reported these violations, the potential award could be in excess of $100M. While that is probably just an estimate, PMC will at least have increased legal fees during the trial. For a company with a tangible book value of $80.2M this trial is one more trouble to go along with the loss of their two biggest customers.

I believe PMC will end up paying a substantial fine though. CVS , Cardinal Health, and Walgreen's have had to pay several fines relating to False Claims Act and the Controlled Substances Act. I sincerely doubt that this lawsuit will end in a warning letter for PMC. While I can't accurately pin a dollar amount to the fine, this is not positive and I believe it will slow acquisitions and divert resources away from the declining business.

Valuation

I believe PMC equity holders are paying a hefty premium for a company that must acquire or perish. With the hodgepodge of nursing homes and facilities around the country it will be very difficult to cut costs to the bone so cutting SG&A as the business declines is not an option. It is simple to see the structural difficulties in this business from the table below which shows what net income would be if acquisitions were halted.

This model assumes that prescriptions per bed rise to 130, an increase over the all-time high achieved in 2012 and that gross profit per prescription increases to $9.00/prescription, again, an all-time high. It also assumes that SG&A would drop 10% per year, something that I believe is unlikely. Finally it assumes that the business would retain the pricing power it has currently, which is unlikely.

Table 3. Impact of Attrition

	2013	2014	2015	2016	2017
Beds	287,213	237,213	187,213	137,213	87,213
Loss of Beds	50,000	50,000	50,000	50,000	50,000
Gross Profit/Bed	$1,170	$1,170	$1,170	$1,170	$1,170
Gross Profit	$336,039,210	$277,539,210	$219,039,210	$160,539,210	$102,039,210
Cash SG&A	$214,000,000	$192,600,000	$173,340,000	$156,006,000	$140,405,400
Interest Expense	$10,000,000	$10,000,000	$10,000,000	$10,000,000	$10,000,000
Income After Tax	$72,825,487	$48,710,487	$23,204,487	($3,553,414)	($31,438,024)

The model above shows that after three years, baring something dramatically different than recent years, PMC would fail to generate income. A simple discounted cash flow (10% discount rate) for the three years of positive income gives a NPV of $123.9 million and assumes that the business could be shut down at zero cost. Adding this optimistic NPV back to tangible book value of $80.6 million creates a potential equity value of $204 million ($6.80/share), more than 45% below the current market capitalization.

This makes no account for the potential fines from the recent DOJ court case.

Conclusion

I believe that PMC is a good short candidate today and the market will begin to realize that the company rarely, if ever, makes money. The loss of two large customers alone raises the valuation of PMC far above long-term averages. Ultimately, I believe the true value of PMC is around $6.80 per share, 45% less than the current market capitalization. The structural difficulties with the business, constant customer attrition, and lack of positive cash flow leave little reason for the company to be valued at a multiple of tangible book value.

True value will be discovered as Wall Street begins to realize that competition is forming, cash returns are low, and that a lawsuit from the DEA will likely result in millions of dollars of fines and lawyers fees.